Front Page Titles (by Subject) Chapter VI: HINDRANCES TO EQUALITY OF RETURNS DUE TO IMPERFECT KNOWLEDGE - The Economics of Welfare
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Chapter VI: HINDRANCES TO EQUALITY OF RETURNS DUE TO IMPERFECT KNOWLEDGE - Arthur Cecil Pigou, The Economics of Welfare 
The Economics of Welfare (4th ed.) (London: Macmillan, 1932).
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HINDRANCES TO EQUALITY OF RETURNS DUE TO IMPERFECT KNOWLEDGE
§ 1. IN the present chapter I shall study in some detail the obstructive influence of ignorance. A flowing stream of resources is continually coming into being and struggling, so far as unavoidable costs of movement allow of this, to distribute itself away from points of relatively low returns towards points of relatively high returns. Success in this struggle is interfered with by imperfect knowledge on the part of those in whose hands the power to direct the various branches of the stream resides. To obtain an idea of the scale of the damage which results from this cause, it is desirable to study briefly certain aspects of modern business finance.
§ 2. First, it must be observed that the returns, which are important as a guide to the right distribution of resources, are those that are accruing in different uses from resources turned into them at each successive moment. The quotient obtained by dividing the net income of a business by the sum of all the money investment made in it in the past would, in a stationary state, afford a true measure of the returns to current investment there. But in actual conditions the measure thus obtained will often be hopelessly misleading. For example, a man may have put £100,000 into a factory for making some particular thing, and the factory may have been destroyed by fire or may have become worthless through obsolescence. An investment of £10,000 now might have just yielded him a return of £2000, or 20 per cent on the new investment, but the return on the total investment will appear as £2000 on £110,000, or less than 2 per cent. This sort of difficulty could hardly fail to obscure relevant facts however excellently business accounts were drawn up and however fully they were published.
§ 3. The next thing that calls for comment is the general character of the accounts as they actually are. In businesses conducted by private firms no statement of profits is made public. In businesses conducted by joint stock companies a certain amount of publicity is enforced by law. But stock-watering and other devices are often used to conceal from outsiders the rate of return that is obtained on the capital actually invested, so that, even when this would afford a reasonable guide to the return on current investment, and, therefore, to future prospects, the way is blocked to anybody other than a specialist. The difficulty is still further enhanced by the fact that the prospects which it is necessary to forecast refer, not to immediate returns only, but to returns spread over a considerable period. It is evident that, as regards these returns, even correct knowledge of the immediate past gives but imperfect guidance. In view of these facts, it might seem that, in existing conditions, ignorance will almost entirely inhibit the tendency towards equality among the returns to resources flowing at any time into different uses. Such a view, however, would be unduly pessimistic. "Though it may be difficult," Marshall writes, "to read the lessons of an individual trader's experience, those of a whole trade can never be completely hidden, and cannot be hidden at all for long. Although one cannot tell whether the tide is rising or falling by merely watching half-a-dozen waves breaking on the seashore, yet a very little patience settles the question; and there is a general agreement among business men that the average rate of profits in a trade cannot rise or fall much without general attention being attracted to the change before long. And though it may sometimes be a more difficult task for a business man than for a skilled labourer to find out whether he could improve his prospects by changing his trade, yet the business man has great opportunities for discovering whatever can be found out about the present and future of other trades; and, if he should wish to change his trade, he will generally be able to do so more easily than the skilled workman could."23 In short, though individual firms may successfully conceal their position, industries as wholes can hardly do so. Ignorance as to the comparative returns to be got by using resources to start new businesses in different occupations may be very great among the general public, but it is probably much less important than it appears to be at first sight among those persons by whose agency the flow of resources is, in the main, directed. Nevertheless, there is clearly room for improvement in the matter of business publicity,24 and, if such improvement were made, ignorance would be lessened, equality in the values of marginal net products promoted, and the size of the national dividend consequently increased.
§ 4. I turn next to the relation between ignorance and the quality of the persons by whom the employment of resources is controlled. In a primitive community investment is carried on almost exclusively by entrepreneurs actually engaged in the various industries and devoting to the conduct of them resources belonging to themselves. Their quality alone is relevant to our problem; and it is obvious that the range of error in the forecasts that are made is likely to be larger or smaller according as able men are or are not content to adopt business as a career. In the modern world a very large part of the investment made in industry still comes from the people actually engaged in particular businesses, who reinvest their profits in them or obtain funds from partners or friends of their own who are fully conversant with all relevant circumstances. It has been suggested that methods of this sort, lying outside the organisation of the money market proper, are employed to direct more than half the total stream of new home investment.25 In addition, however, to these methods, the modern world also has resort to others. A very important part of industry is financed from resources belonging to a great number of other people besides those who actually manage businesses. These other people include, on the one hand, professional financiers, company promoters or promoting syndicates, and, on the other hand, moneyed people among the general public, whom these promoters induce to invest in their ventures. "The promoter's special province," writes Professor Mitchell, "is to find and bring to the attention of investors new opportunities for making money, new natural resources to be exploited, new processes to be developed, new products to be manufactured, new organisations of existing business enterprises to be arranged, etc. But the promoter is seldom more than an explorer who points out the way for fresh advances of the army of industry.... There are always being launched more schemes than can be financed with the available funds. In rejecting some and accepting others of these schemes, the men of money are taking a very influential, though not a very conspicuous, part in determining how labour shall be employed, what products shall be used, and what localities built up."26 In modern industry, then, the direction of a large part of the community's investment is in the joint control of professional financiers interested in company promotion and of the moneyed part of the general public. What is to be said about the capacity and business judgment of this complex directing agency?
§ 5. The comparative capacity for detecting good new openings for enterprise of the professional financier and of the ordinary business man—the entrepreneur investor of former days—is not difficult to determine. First, the professional financier is a specialist in this particular work, whereas to the ordinary business man an opportunity for undertaking it would come, if at all, only at rare intervals. Clearly the specialist is likely to make better forecasts than the general practitioner. Secondly, the international character which the development of the means of communication has in recent times given to many industries has made the advantage enjoyed by the specialist much greater than it used to be when a knowledge of local conditions, such as an intelligent business man would naturally possess, afforded a sufficient basis for a good forecast. Lastly, the fact of specialisation gives freer play to the selective agency of bankruptcy, in eliminating persons who undertake to choose openings for new enterprises and cannot choose well. When the functions of financier and manufacturer are rolled together in one man, the man may flourish through his manufacturing skill—good business tactics—despite of incompetent business strategy. When the two functions are separated, anybody who undertakes the one in which he is incompetent relatively to other people is apt to lose his money and be driven from the field. Furthermore, the efficiency of this natural selection is augmented by the fact that a professional financier undertakes a great number of transactions, and that, therefore, the element of chance plays a small part, and the element of efficiency a large part, in the result. Hence there can be no doubt that the advent into any industry of professional financiers means the advent of persons better able than those immediately concerned in the industry to forecast future conditions. Against this has to be set the fact that the great bulk of those members of the general public, who ultimately supply the funds for the enterprises that professional financiers have organised, are much less capable than ordinary business men of forecasting future conditions. If promoters always looked for the openings most profitable on the whole, as distinguished from those that can be so manipulated as to become most profitable to themselves, this ignorance on the part of people who follow their lead would not, perhaps, greatly matter. Unfortunately, however, it is often to the interest, and it is usually in the power, of the professionals, by spreading false information and in other ways, deliberately to pervert the forecasts of their untutored colleagues. It is this fact that makes the net effect of the modern system upon the distribution of the community's investments among openings of varying merit somewhat doubtful. The prospect of advantage is probably increased when, as in Germany before the war, the flotation of new companies on the basis of shares of extremely low nominal value is forbidden by law; for then a certain number of the poorer and, perhaps, more ignorant persons, who might be easily tricked, are driven away.27 Again, any legislative enactment, capable of being enforced, that checks the fraudulent exploitation of incompetent investors by dishonest professionals tends pro tanto to diminish the range of error to which the general mass of operative forecasts made in the community is liable. "The public regulation of the prospectuses of new companies, legislation supported by efficient administration against fraudulent promotion, more rigid requirements on the part of the stock exchanges regarding the securities admitted to official lists, and more efficient agencies for giving information to investors fall under this head."28
§ 6. A more fundamental remedy is introduced when the work of promotion itself is kept in the hands of bankers—whose reputation, of course, depends upon the permanent success of the business undertakings that they have founded. This is done in Germany. Big German banks retain a staff of technical experts to investigate and report upon any industrial ventures that may be proposed, decide, after elaborate inquiries, which ventures to promote and, in short, constitute themselves a financial general staff to industry. The contrast with the English system is well pointed out in the following passage: "The English joint stock companies (i.e. the banks), conforming to the theory, have abstained in a direct way from flotations and the underwriting business, as well as from bourse speculation. But this very fact causes another great evil, namely, that the banks have never shown any interest in the newly founded companies or in the securities issued by these companies, while it is a distinct advantage of the German system that the German banks, even if only in the interest of their own issue credit, have been keeping a continuous watch over the development of the companies which they founded."29 No doubt, this practice of banks acting as promoters involves great risks and absolutely requires that their capital resources shall be, as they are in Germany,30 very much larger relatively to their liabilities than is usual among English banks; for otherwise losses sustained in the promotion business, or even the temporary "solidification" of funds locked up in this business, might render the banks unable to meet their obligations to their depositors. Moreover, it must be remembered that the position of this country as the banking centre of the world, and, until recently, the principal free market for gold, would make the locking up of bank resources in long ventures more dangerous than in other countries. I make no suggestion, therefore, that the general policy hitherto pursued by British banks has been other than well advised. Nevertheless, there can be no doubt that, when conditions are such as to allow banks safely to undertake the work of promotion, a real advantage results. They are more likely than are certain types of private financiers to look out for openings which really are sound, as distinguished from openings which can be made for a short time to appear sound. It is, indeed, possible that, in some circumstances, where the rival interests of different nationalities are affected, powerful banking institutions operating along these lines may be made the instruments of a political movement, and may allow their conduct to be swayed by other than economic considerations. But this aspect of the matter is unsuited for discussion here.
§ 7. It is not, however, only by acting as promoting agents that bankers can help to direct resources into productive channels. It is true that ordinary bankers in their loans to traders, whether made directly or through bill-brokers, are concerned only with the safety of the debt. The judgment that they make about the capacity of would-be borrowers to meet their obligations involves, when acceptable security is offered, no judgment as to the comparative profitableness of the undertakings into which different would-be borrowers will put the money they succeed in raising. But, when bankers are required to make loans to persons who are not in a position to offer full banking security, they are compelled to assume a more important rôle. They cannot lend on a mere promise to pay, but are bound, in their own interest, to make elaborate inquiry both as to the trustworthiness of the borrower and also as to the purpose to which he proposes to devote the proceeds of the loan. Speaking of the peasant borrowers of India, Sir Theodore Morison writes: "It is useless, however amiable, to believe that the ryot is only thirsting for capital in order to invest it at once in the improvement and development of his estate."31 Again, in the Report on the working of the Co-operative Credit Societies Act in Burma, issued in 1907, it is urged that "in Burma borrowing is mostly due to habit and want of forethought, and not to necessity; that the capital really required to finance cultivation (apart from luxury) is very much less than what is generally supposed, and that mere provision of cheap money, through co-operative societies or otherwise, tends, owing to the existing state of public feeling, to induce waste of income rather than thrift; and, lastly, that in Burma very special care will be necessary to see that the societies are managed in such a way that the prevention of waste and inculcation of thrift are effectively impressed on the members' minds."32 The recognised machinery for exercising this type of control and supervision is provided by People's Banks, such as the Raiffeisen Banks in Germany and their Italian counterparts. These banks evoke the necessary knowledge by a double process. First, the persons brought together as members of the Bank, and, therefore, as potential borrowers, are gathered from a small area only, in such wise that the controlling committee can easily obtain intimate personal information concerning all of them. Only those persons are allowed to become members, of whose probity and general good character the committee have satisfied themselves. In some banks—in the Italian Banchi Popolari, for instance—the committee draw up, ab initio and independently of any particular application, a list of the sums which, in their opinion, may safely be lent to the various members.33 This list is afterwards used as a basis for loans, just as the lists of the communal bureaux de bienfaisance in France are used as a basis for the grant of Poor Relief. Secondly, the grant of a loan is often made conditional on its being employed for a specified purpose, and subject to certain rights of supervision reserved for the lender. Thus, whereas in most land-banks (where material security is taken) "the proceeds of mortgages may be used as the borrower pleases, e.g. in paying off loans, in portioning younger sons, etc.," in the Raiffeisen Banks careful inquiry is undertaken into the purpose for which the loan is required, and provision is made for its recall should the borrower divert it from that purpose.34 The general tendency of this arrangement is to lessen the number of investments made under the impulse of ignorance in undertakings that yield an abnormally low return, and so indirectly to augment the national dividend.
[23.] Principles of Economics, p. 608.
[24.] Cf. Layton, Capital and Labour, ch. iv.
[25.] Lavington, The English Capital Market, p. 281.
[26.] Mitchell, Business Cycles, pp. 34-5.
[27.] In Germany shares were, in no case, permitted of a lower denomination than £10, and they were not usually permitted of a lower denomination than £50. (Cf. Schuster, The Principles of German Civil Law, p. 44.) In 1924 the minimum denomination was reduced to £1 (20 marks), and the usual denomination to £5 (100 marks).
[28.] Cf. Mitchell, Business Cycles, p. 585.
[29.] Riesser, The German Great Banks, p. 555.
[30.] The general practice of the English banks is to supply "banking facilities," that is to say advances, whether by discount of bills or otherwise, that have a short currency only, and not "financial facilities," i.e. advances with a long currency. It is sometimes claimed that this practice handicaps those British industries in which opportunities may arise for the profitable expansion of plant at short notice,—to make possible, for example, their acceptance of some large order which might throw open for them the entry into some new market; for the raising of fresh capital by an issue of shares or debentures necessarily takes time. It is also sometimes claimed that our banking practice makes it difficult for British traders to make their way in those foreign markets where purchasers are accustomed to expect very long credits. It was with a view to meeting these complaints that Lord Farringdon's Committee on Financial Facilities (1916) recommended that an institution should be established with a large capital, not undertaking ordinary deposit banking, but prepared to provide financial facilities both for the development of industries at home and, where necessary, for the conduct of foreign trade. This recommendation was acted upon, and an institution of the kind contemplated—the British Trade Corporation—was granted a Charter in April 1917.
[31.] The Industrial Organisation of an Indian Province, p. 110.
[32.] Report, p. 15.
[33.] Cf. Wolff, People's Banks, p. 154.
[34.] For an account of Raiffeisen and kindred Banks, cf. Fay, Co-operation at Home and Abroad, Part I.